New economy, new economics?


Does the boom in the the dot com and IT industry represent some sort of new economic environment or can it be rationally explained using existing economics? At the same time we will also look at creating an industrial policy for the new economy and look at some of the steps government should take to assist its development.

Market structure

First we will consider the market structure of the new economy, based on firm size and competitve nature. This show us how the current industry has developed without any industrial intervention.


Firm size is consistent with this structure, with a few large firms in the telecom, software and harware sectors. Although there are a lot of smaller software firms, I have classified these as Designers. The software that the web is based on is in effect controlled by a few large firms such as Microsoft, Adobe, Macromedia etc.

As traditional economic theory would suggest with an oligopolistic situation, there are a few medium sized firms who compete heavily with each other and use externalities such as advertising to gain market share. This can be seen from the predominance of hosting and ISP adverts in computer magazines, search engine advertising on television etc. Search engines are particularly interesting as they do not have an obvious product to sell. They operate a free service to end consumers, perhaps even seen as a public good on the internet. Their reliance on advertising means that selling advertising space on the internet iteslf becomes an oligopolistic industry. As they are now on the whole only accepting listings for a fee this public goof has disappeared and the internet is becoming a less dynamic place as new sites are stifled through a lack of visibility.

The smaller mass of dot coms and web designers are operating in a more perfectly competitive market where traditional supply and demand determines price. We will explore the evidence for this such as barriers to entry later.

Market structure itself can be a symptom of the maturity of the industry. Here too the monopolistic firms tend to be long standing players in other similar markets before the new economy came along. Many of these will even claim to have created the new economy themselves, or at least now have a pivotal and undeniable role in maintaing it.

One question is whether in future consolidation in market segmentation will be seen. For instance, will we see bigger internet design houses. Traditional economic theory would see this in terms of vertical and horizontal integration. In terms of the new economy I would argue we can expand this further. Horizontal integration will be a symptom of the maturity of the industry and will happen at the point where competition over web design and dot com business becomes less perfect, the possibility of this we will also need to discuss. If horizontal integration is not possible this will restrict the size that these small firms can become and therefore they will remain risky propositions In this case vertical integration becomes more essential for survival and growth.

Inter-firm co-ordination

The market structure that firms experience when operating in the 'new economy' results in the large number of creative and knowledge industry firms having to coexist with the monopoly and oligopoly suppliers who provide the infrastructure for the industry. One response that government policy can make to assist with the development of the new economy is to provide a local business community which encourages collaboration between small firms specialising in differrent sectors. A shared cost approach may then allow these firms to deal with multinational suppliers in a way that would not be possible without government support.

The government role is primarily one of providing inter-firm co-ordination. As Michael Best wrote in The New Competition; "Inter-firm co-ordination cannot be explored in terms of the traditional hierarchy or market dichotomy, allowance must be made for consultative co-ordination or co-operation amongst mutually interdependent firms each of which specialises in distinct form of the same production chain". In other words, smaller firms need to be encouraged to develop strategic alliances based on what distinct speciality they bring to the market. In a knowledge driven economy, these type of strategic alliances are required to provide small firms with a competitive advantage through mutual problem solving. The fact that these firms are operating at a time of rapid technological change provides their ability to cope with big, more bureaucratic organisations.

At the same time as making small firms more competitive in the new economy, strategic partnerships can reduce the risk that these entities face, in particular when considering the problems faced when encouraging new investment. Co-ordination between companies at different levels of the hierarchy in our market structure model reduces vulnerability to obsolesence as it becomes less likely that a superior product or service can be suddenly introduced which destroys the business model of one of the strategic partners. In effect time is bought for the inter-firm co-ordination to prepare a response to technological change.

However there is one key element that is required to allow for strategic partnerships to operate in this way, effective supply chain management. Many dot com companies failed through their inability to fulfill customer requirements. Market co-ordination across firms is unlikely by itself to produce an effective supply chain as most customers will only wish to deal with one party. Therefore government policy in this area also needs to deliver a cost effective solution that encourages supply chain management amongst the smaller firms in the new economy.

The nature of competition

According to Piore & Sable, competitiveness depends on the institiutions within that particular sector of the economy, what they call the "extra-firm infrastructure". As we have already suggested we see a role for government for providing the environment for this infrastructure to develop to encourage a competitive new economy.

The current state of competition would seem to be fairly predictable through standard economic theory. With web development firms, there has been a first mover disadvantage that has to be balanced against their attempts to gain market leadership in their specialism. In new technologu the first mover bears the risks of cost and unreliability of product. There is a strong risk to these firms of free rider firms emerging that can overtake their initial market leadership. Therefore there was a strong incentive for them to concentrate on creating barriers to entry through heavy concentration on advertising rather than product development or customer service. This is the root cause of the failures of the early dot com companies. They ultimately failed not because the cash ran out before they could dominate the market, but that the market itself had not yet emerged that they could dominate. They may have been better to have concentrated on developing a customer base through innovation and customer service rather than trying to create barriers to entry, but it is too easy to conclude this with hindsight. Joseph Schumpeter's description of the process of creative destruction would seem to descibe this situation perfectly with the ability to copy ideas and technology. However, one must add that the destruction appeared to have more impact on the emerging market rather than the traditional retailing it was meant to destroy, something that Schumpeter didn't consider.

Price competition also exists in the new economy to an unusual extent. Consumers are unwilling at the current time to pay for web based services on the whole. Individuals appear to expect something for nothing on the internet. The ability to transfer technology from one application to another has resulted in nearly as good services and software being available for free, destoying the business plans of many dot coms.

Returning to our original market structure model, the monopoly suppliers are making monopoly profits in the new economy in supplying the background infrastructure. The small firms are surviving or falling depending on their success in making money out of this competitve market, but 50% at least are making money at any one point in time. It is the oligopoly firms that struggle with the current model in the new economy. The concept of non-price competition outlined by Schumpeter is clearly important here. The firms such as content providers, advertising agencies and search engines are now trying to work together more on a strategy for the sector rather than competing on an individual company basis. Whether they will be able to maintain this attempt at income generation is doubtful. The amount they would need to spend to create a big enough barrier to entry to extract significant subscription income from the end consumer is probably too large to justify the investment. It may be that public policy will be required to intervene and to treat these services as public goods rather than competing firms in an open market.

Culture of the new economy

Firms in the new economy are developing their own culture as the industry develops. The more traditional parts of the industry such as software, telecoms and retailers tend to exhibit the same culture they would had before an on-line economy developed. New media firms and designers however have developed their own style of operation independently from this. Again this can be seen in terms of firm and market size that they are operating in.

The larger firms have to operate to a system of industry standards, which directly affects their culture and the way they behave. A consistency of approach is required for software developers and hardware manufacturers so as to encourage inter-operability of their products. The monopoly firms in the industry, such as Microsoft are frequently the standard setting body for other dependent firms, a position that drives much of the potential anti-trust action against them. Like many other monopoly and oligopoly suppliers in other industries, there is a tendency to over production as a result of their position in the market due to the high fixed costs caused by creating the barrier to entry that such industry standards in effect are (although this is not an argument against the potential economic benefits that standards themselves generate - there is clearly a difference between open and proprietary standards with open encouraging entry and proprietary restricting it - in either case the way the firm acts in creating these standards is the same).

Firms in the new economy can also be distinguished between those that operate on a hierarchical basis and those that operate on a knowledge basis. The hierarchical firm attempts to create control over the market and its external environment through dominance. The knowledge firm attempts to participate and contribute to a market through the development of strategic alliances on a complimentary basis. In theory the hierachical firm should be controlled in its actions over the market through anti-trust and other forms of market regulation. However with new technology areas the rules set by regulators cannot keep up with industries that by their nature are evolving and do not develop along traditional lines.

The new economy is often described in terms of having a 'youthful' culture. Economists would not be suprised at this if they went along with Marshall description that "Firms, like trees, gradually lose vitality, and one after another they give place to others, which ....... have on their side the vigour of youth". This is more a bioloigical theory of the firm than Schumpeter's procees of creative destruction. It almost implies that the death of the current culture in the new economy is almost certain as the firms themselves mature; that the industry becomes less exciting and more 'traditional'. This would seem unlikely, unless this is driven by a change to the market structure and small firms combine to produce large international firms of web designers, who proceed to be less knowledge and more hierarchically based. As mentioned before vertical integration would appear unlikely in the new economy even in the longer term as it would result in the creativity within the industry and the role of the entrepreneur altering fundamentally.

Economics or entrepreneur

Internet technologies emerged originally through the idealism of a few individuals. The big companies of the new economy still tend to have a leading light or figurehead at the helm whose identity is rarely separable from the firm, Bill Gates at Microsoft for instance. As described by Coase, in perfect competition price movements decide production, the equivalent of technological developments in the new economy. However in firms the entrepreneur-coordinator directs production. Firms emerge because of uncertainty and risk. As we have questioned before it is important in the new economy in particular to what degree is risk shared through strategic alliances. By and large this can also be interpreted as to how much the firms taking part in such an alliance share information between them, this not being just about trust in the partnership but a case of sharing information being an indicator of sharing risk.

This interpretation would be significantly different from Joan Robertson's description of firms being "islands of unconscious power in the ocean of unconscious cooperations like lumps of buttermilk coagulating in a pail of buttermilk." Sharing risk requires cooperation between individual entrepreneurs to be made in awareness of the effect they are having on the overall market. This is not just true for oligopolistic firms who by nature attempt to limit competition in their sector of an industry (through barriers to entry for instance) but is equally as true for the small firm operating in a local market. The question is more of whether the small firms operate in this way through necessity or through compulsion, due either to government industrial policy or through the actions of the bigger firms in an industry. One example of this would be re-seller network, where big firms avoid direct sales to small and medium sized enterprises (SMEs) through a partnership network of smaller firms who reduce the administrative burden of selling direct. This does however have a price and dependence cost on the SME who wishes to take advantage of new technology, something that government industrial policy is attempting to tackle after the event rather than through establishing an industrial policy through the small new economy firms directly.

An industrial policy that encourages competitive and cooperative entrepreneurialism in a local business district would still contain the problem of power relations between the participants in strategic alliances. However it would develop some form of community that would develop its own culture and informal rules which would allow the positive externalities of the market to coexist with the entrepreneurial nature of each participant.

Innovation in the new economy

Having considered how strategic alliances are used to put structure to the role of the entrepreneur in the new economy, we need to consider how innovation and change develops within the new economy and how this impacts the economy as a whole. Schumpeter distinguished between price competition and the process of creative destruction which forms new markets within the whole of an economy. He defined this process of creative destruction as being the "process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly creating a new one." This implies that innovation may be the key to the new economy, rather than a process that produces greater efficiency of exchange (and hence price competition) in the economy as a whole. This helps to explain why the market structure involved in the new economy exists and why this will not result in the certain destruction of monopolies and oligopolies such as Microsoft.

The firm in the Schumpeter analysis is an agent of change within the economy, whilst the entrepreneur is the source of ideas that bring change about. This again provides support for a role for an industrial policy in encouraging the conversion of ideas into firms and firms into business communities. The key to developing the new economy is how far can the single entrepreneur with an idea effectively turn this into a successful and sustainable firm.

The entrepreneurs that are active in the new economy are likely to be obsessed with the growth and development of the firms rather than price competition and profit maximisation for its own sake. Many new firms beleive that there idea has a perceived value and benefit that shouldn't be devalued through price negotiation. The concept of profit maximisation itself can only be an abstract notion as the creative destruction process brings about external disturbances to the competitive market.

This also explains why many e-commerce firms will fail. In reality, the whole concept of a new economy itself may be driven into extinction as the speed of change renders business plans obsolete almost before they are written. Venture capital may constrain entrepreneurial firms to operate as profit maximisers in a market where this is a concept that cannot exist. Rather than focussing on the idea, the innovation , they are forced to focus on behaving like a firm in a mature industry would. This is self-defeating. Penrose identified that firms are limited to growth by the boudries of teamwork, based on their objective and experiential knowledge. Innovation and the development of a firm is a skill that entrepreneurs are unlikely to develop during the start-up phase of a firm in the new economy. If venture capital is unable to provide this assistance then there is a role for an industrial policy for the new economy to achieve the same aim.

Survival in the new economy also requires expansion to a certain extent. Firms will only become profit maximisers as they progress up the market structure and develop established niche and speciality areas that are of value. The pressures of a firm from this type of development and expansion are even greater as they begin to require beuraucratic control mechanisms rather than the direct control the entrepreneurial firm tends to exhibit. We again come back to the strategic alliances that were discussed earlier. As Richardson identified, firms tend to internalise similar activities and externalise complementary activities. If firms in the new economy and the innovations they bring to market are to thrive, they need to have recognised this in the way they operate with both allies and competitors.

Structure revisited

Having considered the way that firms have developed in the new economy, it is useful to now revisit some of the market structure elements that have emerged from this analysis. To what extent, for instance, can the new economy be described as a productive system (of the type outlined by Best), where a group of connected institutions through which goods and services are created, resulting in the continuous improvement of products and processes.

We have outlined that small firms will continue to exist in the peripheral sectors of the new economy, but it is from these type of firms that new ideas tend to emerge. One of the problems that many of the new economy creates for these firms is when they try to mimick market structures of traditional industries too early in the business maturity cycle. This tends to lead to high marginal cost and pricing structures that limits the growth of the idea involved. At the other extreme are firms that believe they can break completely with ideas of economics and pricing which often has resulted in business models that were unsustainable even in the short term (advertising led models for free services are good examples of this).

The firms that claim to provide the backbone to the new economy, the technology and infrastructure provides, exhibit clear signs of traditional oligopolistic behaviour. Non-price competition through heavy advertising and strategic alliances all are used to justify the losses that these companies currently make, on the basis that they will be in the short term whilst the market matures. However, as Baumol, Panzar and Willig identified, if all producers have access to the same technical and productive characteristics their consumers will respond quickly to price changes, yet the established firms cannot respond swiftly enough when a potential entrant sets up for business at cheaper prices. Then in this case barriers to entry will not be maintained. This would appear to make sense as technology becomes cheaper as well as better. Galbraith identified that oligopolies frequently were faced with oligopoly customers, the idea of counterveiling power. The technological infrastructure companies tend to be selling to the big multinationals and other technology companies, therefore they may be unable to make excess profits due to the market structure of the economy.


Most of the development of the new economy can be explained through existing economics, whether this is basic economics of supply and demand or elements of industrial economics using the theories of firms and markets. This does not mean that firms in the new economy should behave as their traditional market contemporaries do, in particular they should seek out strategic partnerships with complementary firms rather than trying to control the supply chain through horizontal and vertical integration. Such a focus on firm size is likely to reduce the creativity of the industry as more bureaucratic forms of control are required.

For government policy the encouragement of small business districts is not a new idea and does not just apply to firms operating in the new economy. A recognition that some elements of the internet and software markets are public goods (such as search engines) will need to develop before the new economy has a stable enough platform for its long term development.